Question

Question 5 (14 marks) The Basket Weavers Company has 100,000 units of semi-annual coupon, 20-year bonds outstanding that are currently selling at par value ($1000). The coupon rate of the bond is 7.47%. The company also has 1 million shares of 10.5 percent preferred stock outstanding and 5 million shares of common stock outstanding. The preferred stock has a par value of $100 and is selling for $60 per share. The common stock has a beta of 1.5 and is selling for $40 per share. The U.S. Treasury bill is yielding 3 percent and the return on the market portfolio is 12 percent. The corporate tax rate is 35 percent. (a) Calculate the cost of equity of the Basket Weavers Company. (2 marks) (b) Calculate the cost of preferred stock of the Basket Weavers Company. (2 marks) (c) Calculate the after-tax cost of debt of the Basket Weavers Company. (2 marks) (d) Calculate the weighted average cost of capital of the Basket Weavers Company. (5 marks) (e) Should the weighted average cost of capital be used as a required return for an investment project which has a much higher risk than the overall risk of the company? Explain briefly. (3 marks)

Answer 1

(a ): Cost of equity (Required rate of return)= 16.50% as follows:

А B с D E F 1 As per CAPM, Re= Rp + B*(Rm-Rf) 2 Where Re = Expected return on risky asset, R = Risk free rate of return, B= Beta coefficient of the asset, 3 and Rm = Return on market portfolio. (Rm-R-) constitutes market risk premium. 4 5 Formula Cell reference Value 6 Given, Risk free rate of return (Rt) Given 3.00% 7 Return on market portfolio (Rm) Given 12.00% Beta (B) Given 1.5 9 (Rm-Rt) H7-H6 9.00% B*(Rm-Rt) H8*H9 0.135 11 Required rate of return= R++ B*(Rm-Re) H6+H10 16.50% oc LO

(b ): It is assumed that preferred stock is irredeemable.

Cost of preferred stock= C/P

Where C= yearly dividend and P= current price

Given, par value= $100, dividend rate= 10.5% and p[rice (P) = $60

Therefore, yearly dividend, C= 100*10.5% = $10.50

Plugging the values, Cost of preferred stock= 10.50/60 = 0.175 Or, 17.5%.

(c ): Since the bonds are selling at par, pre-tax cost of debt is equal to coupon rare that is 7.47%

Given, tax rate= 35%

Therefore, after-tax cost of debt= 7.47%*(1-35%) = 4.8555%

(d ): Weighted Average Cost of Capital (WACC) = 11.936365%

Calculation as follows:

А B С D E F G 1 Weighted Average Cost of Capital (WACC) is calculated using the following formula 2 WACC= (E/V)*Re +(P/V)*Rp + (D/V)*Rd) 3 Where E= Market value of total equity, D= Market value of total debt, P= Value of preference shares 4 V=Total capital (E+P+D), Re= Cost of equity, Rp= cost of preference shares, Rd= after tax Cost of debt 5 Amounts in $ 6 Formula Cell reference Values 7 Given, Value of equity (E) 5,000,000*$40 65,000,000 8 Value of Preference shares (P) 100,000*$60 13,500,000 9 Value of debt (D) 100,000*$1,000 52,500,000 10 Cost ofequity capital (Re) Calculated separately 16.50% 11 Cost of Preference shares (Rp) Calculated separately 17.5000000% 12 After tax Cost of Debt (Rd) Calculated separately 4.8555% 13 Total capital (V) E+P+D G7+G8+G9 131,000,000 (E/V)* Re (G7/G13)*610 0.08187023 15 (P/V)* Rp (G8/613)*G11 0.01803435 (D/V)*Rd (G9/613)*G12 0.01945906 17 WACC= (E/V)*Re +(P/V)*Rp + (D/V)*Rd G14+G15+G16 11.936365% 14 16

(e ): Weighted average cost of capital is the overall cost of capital of the company which is commensurate with the average risk of the company. In case a single project has higher risk than the average of all projects of the company, WACC shall not be treated as the required rate of return. Appropriate risk premium has to be added.